8/14/2019 Her Majesty's Soft Dollars

1/3

CnsE SruoY

H.E$$ffi ffi q wrE$wry ffi ffi ff m'$# &ff geg,$*Hmtrm ffi m ff $ a* qe w m$i ffi $,T # trs $ trf$w ffi ff Lq fr ffi E ffi #flE ffi # ffi fl.. $

gpw ff E$g$# ffi$##$ffi ffi ff+$$i,#ffi ffi $ $3#,$Hffi "

]nvestment managers - and not, as is customary, the clients ofI institutional investors - should eat the research costs generated bytransactions ir-r managed accounts.It is a brave new world, but that is the conclusion of a controver-sial report on the U.K. pension industry, inked by a former chiefexecutive of Gartmore Investment Advisers."Clients' interests would be betterserved if they required fund managers toabsorb the cost of any commissions paid,treating those commissions a,s a cost of thebusiness of fund management, as theysurely are," declares Paul Myners, in the;::::---*sioned by the u.K. sovern-The conclusion is nor surprisingbecause there is a wide-spread perceptionthat these costs, associated with soft-dollarpractices, are prone to corruption. It hasbeen an issue in the U.S. since the 1975birth of negotiated commissions. An Actof Congress was needed back then topermit commission payments forresearch services. Indeed, the majoriry ofplan sponsors instruct investment man-agers to trade through a selected broker.The broker agrees to rebate part of thecommissions to the pension p1an. Thatreduces commission pools available tothe manager.Still, eliminating soft-dollars risks seri-ous market damage. It risks taking 'soft'28

expenditures out of commissions and putting them with the principalprice.In most scenarios, the clients of institutional investors, includingpension plans, mutual fund shareholders, 401(k) participants, willnot end up winners. Since 1975, the cost ofprocessing an ordinaryrransaction has plummeted to around a penny or two per share. Yet,

Her MaiG$Iy3$ofi llollru$

Traders February 2002

8/14/2019 Her Majesty's Soft Dollars

2/3

at the same time, average fuIl-service com-mission rates remain about six cents a share.In other words, the charges have not comedown in line with the cost of providing thebasic service.

Sure, six cents a share may be justifiedfor handling difficult transactions. Brokersearn this level of commission when theyhandle a large and delicate order. Still, nomatterhow simple the trade, the going ratefor non-automated trading is still near sixcents. No market force, buyside, sellside,nor even plan sponsors, seems to want tobring the price down. The reason: Shelteredunder this six cents 'umbrella' is a host ofinstitutional research and tools accepted asessential to asset management.

Vital Sen'icesMost managers carefully budget theirsoft-dollar services. Many have administra-tors who see that soft-dollar standards arefollowed. Yet the heart of the Myners reportnotes that the services acquired are not ade-quately scrutinized to determine whetherthey are indeed vital.

Here's an example: In today's environ-ment, a large manager is likely to receive adozen or more research recommendations asbrokers srrive to display their competence.This sounds excessive, but the value ofinfor-mation is not as evident as suggested byMonday morning quarterbacks. Perhapsmost of the imponant research is redundant,but who wants to disregard research by Ms.X under this arrangement? She might stum-ble across something important that isignored by other analysts.

Suppose - under the Myners scheme- inys5smgnl managers picked up the costsgenerated by commissions: How wouldpension management be affected? Howwould it affect trading?

Let's begin with a simplified example ofa $100 million investment fund with a 50basis point management fee. Assume annualturnover at a rypical rate of 100 percent,with a five cent commission on an average$40 stock. Such an account would carry a$500,000 managemenr fee and $250,000 incommission payments.Everything else being equal, directlyincluding the commission costs in the man-agement fee would raise the fee 50 percent.

CnsE Sruov

30 Traders February 2002

8/14/2019 Her Majesty's Soft Dollars

3/3

Or would something else happen? Fouralternatives are examined in the sidebars:

1. Fees rise to cover the increasedexpense transferred to the manager.2. Managers drastically reduce researchpurchases.3. Managers reduce commissions toreflect only trade costs.

4. Costs slide over from the all too visiblecommission ro hidden rransacrion cosrs.

In 1989 this writer attended a confer-ence on the state of the market. The head ofone major sellside dealing desk warned thebuyside: If brokers were not adequatelycompensated for their services, they wouldbecome more an adversary than a partner ofthe buyside. A move away from soft doliarscould accelerate that trend.You either believe that the research andmarket feel of the brokers are valuable ornot. Those who see value would want toavoid a situation where the services becomeavailable only to those able to pay up.Transferring the operational costs ofactive portfolio management to the man-ager, as Myners recommends, sounds good.Unless the costs of services are recoveredthrough increased fees, the only alternativefor managers would be to eliminate servicesor transfer costs in ways that risk reducingthe value of active management.However, the real question is whethersoft-dollar practices are a problem that needsfixing. There is already effective low-costcompetition to active investment manage-ment: The index funds serve investors whopreGr this low cosr. low turnover investmentstrategy. Srill. active managemenr conrinuesto thrive as an option for those who preferto place a sage in charge of their pordolios.And the sages do need the benefit ofspeciaiknowledge.The Myners report, nonetheless, deservespraise for its fresh look ar an imporrantissue. But the solution proposed doesn'tseem to lead to the promised benefits. That,perhaps, helps explain why the soft dollarbusiness has remained so resilient.\X/ayne r[/agner is chairman of the PlexusGroup, a trade execution consuhant based inLos Angebs.

CnsE Sruov

32 Traders February 2002